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Business interruption in the land of earthquakes

A large Japanese earthquake could have a devastating effect on the continuity of critical industries in the country and their earnings. By Dennis Kuzak and Masanori Kobayashi

A study of 32 Japanese companies in eight critical industries, published in November 2007 by ABSG Consulting, reveals that a very large earthquake could generate property damage plus business interruption losses equivalent to two years of pre-tax earnings for the chemical industry, and more than one year pre-tax in the precision machinery and petroleum sectors, in the absence of mitigation steps. Other industries studied would also suffer severe consequences. Japan is often referred to as the land of earthquakes. The Japanese Central Disaster Management Council projects that losses from these disasters, including property damage and business interruption, would be measured in trillions of yen (I trillion yen = $9.3 billion).

The July 2007 Niigataken Chuetsu-Oki earthquake, defined as Magnitude 6.8 by the Japan Meteorological Agency (JMA), underscores the potentially damaging business consequences of large earthquakes. It damaged a factory owned by Riken Corporation, which had a 50% share of the domestic market for the piston rings required by automobile manufacturers. The overall recovery effort took two weeks, and automobile production dropped about 120,000 units for that period, creating a significant contingent business interruption loss.

The Mid Niigata Prefecture 2004 earthquake, JMA Magnitude 6.8, struck a Sanyo Electric Company semiconductor plant in Ojiya City. Although the factory buildings were not damaged severely, the production machinery was. One part of the production lines was closed for two months, and the entire recovery effort took more than five months. Sanyo

Electric reported losses related to direct equipment damage of approximately 42 billion yen ($439 million), and a business interruption loss of about 31 billion yen ($290 million.) According to JMA, there is a 60-70% probability of a Magnitude 8.0+ earthquake in the Tonankai trench within the next 30 years.

The Japanese Central Disaster Management Council estimates that the amount of damage from a Tonankai-Nankai earthquake would be 33 trillion to 48 trillion yen ($318 billion to $462 billion), including business interruption. Considering these risks in Japan, ABS Consulting examined the potential direct physical damage and business interruption loss caused by earthquake shaking for companies in the chemical, precision machinery, petroleum, steel, nonferrous metals, automobile, electronic and pharmaceutical industries. The study used EQECAT’s JapanQuake earthquake model to simulate the hazard and damage.

While the ABS study is not representative of all Japanese companies, it demonstrates how the earnings impact for many industries can be substantial. These risks are not theoretical; they are real. Failure to implement prudent mitigation options could prove extremely costly.

The study also showed that since many of the industries in Japan are interdependent for raw and component materials, or related by the just-in-time manufacturing supply chain, additional contingent business interruption losses could add significantly to the initial loss estimates. Additionally, in large earthquakes extensive damage can occur in public utility lifelines and other infrastructure, including railways, roadways and harbour facilities. This must also be factored into the contingent business interruption exposure analysis.

Japan’s business leaders and risk managers can reduce the potential consequences of such disasters by taking two specific steps. The first is to initiate a fresh and detailed review of an organisation’s exposure to potential catastrophes, with special attention to possible business interruption and contingent business interruption loss.

The second step is to consider a wide range of mitigation strategies, ranging from traditional insurance products and alternative risk transfer instruments to practical engineering and technology solutions. Quantifying the relative cost-benefit received from each mitigation action can help optimise the overall risk strategy.

Additional risk mitigation methods may also include traditional insurance products or alternative risk transfer instruments such as catastrophe bonds and derivatives. Several leading organisations in Japan have successfully securitized their earthquake risk, among them the East Japan Railway.

To limit the potential financial impact of earthquakes, and other natural and man-made perils, each business must decide which mitigation methods best suit its particular situation. No one method is likely to be a panacea but lack of careful analysis and action could be financially disastrous.

Infrastructure is an essential element in the immediate, as well as long term, recovery from a catastrophe. Identifying geological risks to infrastructure projects is, thus, an essential part of catastrophe risk management. By Matthew Free and Sara Anderson